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Barron's MFQ

Sprucing Up

By

Lawrence C. Strauss

Updated Oct. 11, 2004 12:01 a.m. ET

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THE MUTUAL-FUND INDUSTRY, rocked by late-trading and market-timing scandals over the past 13 months, has spent a lot of time and money trying to restore its credibility and trust with investors. So far, it's been an uphill battle, although the industry has scored some victories. "I would say it's a mixed bag," says Don Phillips, a managing director of Morningstar, the Chicago-based fund tracker. "I would give the industry a good mark overall, but not a great mark."

On the plus side, in his view, "the industry has accepted, somewhat begrudgingly perhaps, a significant amount of change and a higher level of transparency in the wake of these scandals."

Of course, these changes came after the scandals gave regulators the upper hand.

"There's no question that without [New York State Attorney General Eliot] Spitzer and the SEC, the fund industry would not have moved an inch toward more disclosure," asserts Jim Lowell, editor of the independently published Fidelity Investor newsletter.

Even John Bogle, founder and former chairman of the Vanguard Group and a frequent critic of mutual funds, describes the industry as "absolutely better off." Overall, he gives it a B-minus.

Why not a better grade?

For one thing, Bogle and others have faulted the fund business -- or at least influential figures like Edward C. Johnson III, chairman of Fidelity -- for opposing the Securities and Exchange Commission's proposal to require fund boards to have an independent chairman, a measure that was eventually adopted despite intensive opposition and lobbying by the industry. "But now I sense a willingness to at least accept it, now that it's in place," says Bogle.

"Most of the firms involved have tried to clean up their shop pretty quickly and have adopted a variety of different reforms," observes Robert Pozen, chairman of MFS Investment Management, which settled with regulators in February over market-timing issues.

Indeed, it's been a tumultuous stretch for fund firms. State and federal regulators have rung up more than $2 billion in fines and restitution. A string of settlements has collared, among others, Strong Capital Management, whose founder, Richard Strong, resigned from the firm and paid $60 million in fines in connection with market-timing abuses, plus: Alliance Bernstein; Putnam Investments; Janus Capital Corporation; and MFS Investment Management, all caught up in market-timing improprieties. Many others, including Invesco Funds Group, Nations Funds and Pilgrim Baxter & Associates, were also tainted by the scandals.

For sure, the landscape has shifted since Spitzer announced his first settlement in September 2003. That case involved Canary Capital Partners, a hedge fund that was using the funds of four firms --
Bank of America
via Nations Funds, plus One Group, Janus Capital Corporation, and Strong Capital Management -- for market timing. In exchange, Canary was parking "sticky" assets, enabling the four companies to generate fee income. Nations Funds was additionally flagged for allowing late trading.

But is the industry, which manages more than $7 trillion, really on the road back? For many observers, both within and outside Fundland, the key to a true recovery lies in whether fund directors fulfill their statutory duties, laid out in the Investment Company Act of 1940, especially the implied directive that they protect shareholders. Critics have long complained that most fund directors have exercised little oversight.

"The first and most noticeable change is the involvement of independent directors and trustees," says Barry Barbash, an attorney who heads the asset-management group at Shearman & Sterling in Washington and who is a former director of the SEC's Division of Investment Management. "In the past, they took a role of more of a passive reviewer."

That's changing, as boards delve more aggressively into such issues as conflicts of interest and potential abuses linked to sales commissions, he says. "There is a tremendous amount of attention being paid to compliance," says Barbash. "Board meetings that used to take two hours are taking eight hours. One-day meetings are becoming two-day meetings." (Last fall, Putnam asked Barbash to help review and overhaul its compliance procedures.)

This isn't to suggest that a sea change has taken place in the boardroom.

"The test is whether they are going to have actual boards that are looking out for the shareholders' interests and whether they are going to be looking critically at costs, not just management fees," says David D. Brown IV, bureau chief of the Investment Protection Bureau in the New York State Attorney General's Office, who has overseen the office's mutual-fund cases. "I hope to see those [costs] coming down as the new boards begin to flex their muscles."

For all of the analysis of the scandals and their effects, what sometimes gets overlooked is that many fund complexes, including Fidelity,
T. Rowe Price
and the
Vanguard Group,
were beyond reproach. "The companies that handled it the best were the ones that were not caught in the scandals and they deserve credit," says Gary Gensler, co-author of The Great Mutual Fund Trap. "This was a wide-ranging problem."

Another theory is that the outflows from the tainted firms reflected not just public disgust with dishonesty, but poor investment performance as well.

Janus, Putnam, MFS, Invesco and Alliance Bernstein, among others, had high-profile funds with disappointing returns during the recent bear market, points out Neil Bathon, president of Financial Research Corp., which does research on the fund industry.

At the same time, some observers maintain that the overall mess wasn't that big a deal for many individual investors. "There was no grieving victim in the fund scandals and no weeping couple that you could put on ABC News, talking about how their retirement plans have been destroyed because they lost everything in Enron stock," observes Phillips. "Instead, what you would have is someone with a green eyeshade on, saying, 'I believe that my $11,000 account should be $11,007.' It just didn't make for good theatrics."

What's more, as if to underscore continuing investor confidence in the industry, net cash inflows have been very strong this year, despite lackluster markets. Through August, $128.6 billion had poured into stock funds this year, compared with $80.6 billion in the corresponding 2003 period, according to the Investment Company Institute, an industry trade group.

"I just don't think [the scandals] really resonated with individual investors in a meaningful way," says Bathon. "To a lesser extent, financial planners and brokers probably have a deeper and ongoing relationship with the firms, and I don't think they got that worked up, either."

However, the funds that appear to have pulled in the most assets this year are those that appear squeaky-clean. In addition, the scandals did resonate with institutional investors, some of whom pulled millions from the tainted firms.

Last October, after the market-timing abuses surfaced at Putnam, Michael Fitzgerald, Iowa's state treasurer, withdrew nearly $600 million his state had invested with the firm in a European-equities account. "The ethical question is a bigger question with us now than it was before," Fitzgerald says. "We certainly want companies to understand what our policy is. It's clearly on everyone's radar screen that ethics are important."

Roz Hewsenian, a managing director at Wilshire Associates, which works with institutional investors, notes some important changes. "We would meet with the CEO and ask about compliance and the compliance process and how that was handled," she says. "Now we're actually pulling the compliance officer aside and asking questions like, 'If the CEO is blocking you in some ways, who do you go to?' "

In terms of working to regain trust with institutional investors, Hewsenian puts Alliance Bernstein and Putnam at the top of the list, among the firms that had problems.

Lewis Sanders became chief executive at Alliance Bernstein in June 2003, and Charles "Ed" Haldeman took over at Putnam in November. Hewsenian describes both as "tireless in getting on planes and running around the country and making sure their clients and constituencies were kept informed about what was going on." In a $600-million settlement with Spitzer's office over market-timing abuses, Alliance agreed to slash fees by 20%, or about $70 million annually, over the next five years.

Nonetheless, Alliance and Putnam have bled assets, clearly hurt by the scandal's fallout.

Last November, Putnam's net redemptions for long-term funds topped $13 billion, according to Financial Research Corp. Redemptions have continued, albeit at a slower pace. In August, investors pulled out $1.7 billion, the first time the monthly number fell below $2 billion since last September.

Putnam would make an interesting case study of crisis management. Soon after the scandals broke, it turned to Haldeman, who was promoted upon the departure of longtime CEO Lawrence Lasser. In April, Putnam reached two separate settlements, each for $55 million -- one with the SEC and the other with Massachusetts -- in connection with market-timing abuses.

In trying to turn Putnam around, Haldeman:

Reviewed employee trading records going back six years.

Fired 15 employees, in connection with market timing.

Named a new chief financial officer, general counsel and chief operations officer.

Required employees to hold Putnam funds they invest in for at least 90 days.

Ordered portfolio managers to hang onto investments in funds they run for at least one year.

Imposed a 2% trading fee for shares exchanged or redeemed within five days.

Cut sales charges on class A shares to a maximum of 5.25% from 5.75% for stock funds and 4.50% from 4.75% for bond funds.

What's more, Putnam is reporting how much its portfolio-management teams earn and revealing senior managers' holdings in its funds -- disclosures that go beyond the SEC's requirements.

The announcement that it would begin such reporting was made in late September in conjunction with the California State Treasurer, Phil Angelides, who last fall urged the California Public Employees' Retirement System (CalPERS) and the California State Teachers' Retirement System (CalSTRS) to pull a combined $1.5 billion from Putnam.

While neither system has returned to Putnam, last week, Putnam scored a big psychological victory when the Commonwealth of Massachusetts agreed to hire it to run $250 million of pension money. Massachusetts had fired Putnam last fall.

Would Fitzgerald, the Iowa state treasurer, consider doing the same? Not any time soon. "For me it would take an awful lot -- years of credibility for dealing with their other investors and building up trust with those folks, and a proven record of taking care of their customers," he says.

Another firm that's made lots of internal reforms is MFS. Yet it, like Putnam, continues to lose assets, although redemptions have slowed. In August, net outflows in long-term funds totaled $545 million, down from $902 million in June.

MFS began the year with $140 billion in assets, compared with $137 billion recently. "We have had some assets trickle out on the retail side, but that has gradually slowed down," Pozen says.

A positive, he says, is that his company's institutional business has stabilized. "When you start bringing in large institutional accounts, that's really the turning point," Pozen observes. "While there are still a few consultants that give us a hard time, most of them have put us back on their list." MFS recently landed a $500 million investment mandate from a large West Coast pension fund, and it's also won new institutional business in Japan and Singapore, Pozen says.

Although most of the high-profile cases involving major fund complexes appear to have been wrapped up, the investigations aren't over. "We are still looking at a number of companies," says Brown of the New York State Attorney General's Office, declining to be more specific. "There are companies out there that have serious problems and just hope this scandal and the consequences of their behavior will somehow pass them by -- but that's not going to happen."

The fund industry will face other tests, for sure.

"The key question is what will be the next wave of problems, and will the industry be able to deal with them effectively in the interest of shareholders?" observes Barbash.

While Morningstar's Phillips says the industry "will be in better shape for years to come because that sense of infallibility is gone," he still has concerns. Despite new SEC rules, plus reforms at individual companies, "the industry solution today is the same as it was 15 months ago, which is 'Trust us,' " he says.

"You have to assume today there is a lot more incentive for fund companies to make sure these things don't happen, because they've seen the penalty to those firms who let this happen," Phillips adds. "But there still isn't anything you could point to that says here is the reason late trading couldn't happen again," he continues. Yet one thing that argues in favor of a cleaner investing environment, he says, is self-interest. "In the long run in this industry, good behavior wins," he says.

And, as recent history shows, oftentimes, bad behavior -- and performance -- will eventually be punished.

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